322 PART 2 Important Financial Concepts
expected return, kˆ
The return that is expected to be
earned on a given asset each
period over an infinite time
horizon.
- A great deal of theoretical and empirical research has been performed in the area of market efficiency. For pur-
poses of this discussion, generally accepted beliefs about market efficiency are described, rather than the technical
aspects of the various forms of market efficiency and their theoretical implications. For a good discussion of the the-
ory and evidence relative to market efficiency, see William L. Megginson, Corporate Finance Theory(Boston, MA:
Addison Wesley, 1997), Chapter 3.
LG4 LG5Hint Be sure to clarify in
your own mind the difference
between the required return
and the expected return.
Required returnis what an
investor has to haveto invest in
a specific asset, and expected
returnis the return an investor
thinks she will getif the asset is
purchased.
Hint This relationship
between the expected return
and the required return can be
seen in Equation 7.1, where a
decrease in asset price will
result in an increase in the
expected return.
7.3 Common Stock Valuation
Common stockholders expect to be rewarded through periodic cash dividends
and an increasing—or at least nondeclining—share value. Like current owners,
prospective owners and security analysts frequently estimate the firm’s value.
Investors purchase the stock when they believe that it is undervalued—when its
true value is greater than its market price. They sell the stock when they feel that
it is overvalued—when its market price is greater than its true value.
In this section, we will describe specific stock valuation techniques. First,
though, we will look at the concept of an efficient market, which questions
whether the prices of actively traded stocks can differ from their true values.Market Efficiency^2
Economically rational buyers and sellers use their assessment of an asset’s risk
and return to determine its value. To a buyer, the asset’s value represents the
maximum price that he or she would pay to acquire it; a seller views the asset’s
value as a minimum sale price. In competitive markets with many active partici-
pants, such as the New York Stock Exchange, the interactions of many buyers
and sellers result in an equilibrium price—the market value—for each security.
This price reflects the collective actions that buyers and sellers take on the basis of
all available information. Buyers and sellers are assumed to digest new informa-
tion immediately as it becomes available and, through their purchase and sale
activities, to create a new market equilibrium price quickly.Market Adjustment to New Information
The process of market adjustment to new information can be viewed in terms of
rates of return. From Chapter 5, we know that for a given level of risk, investors
require a specified periodic return—the required return, k—which can be esti-
mated by using beta and CAPM. At each point in time, investors estimate the
expected return, kˆ—the return that is expected to be earned on a given asset each
period over an infinite time horizon. The expected return can be estimated by
using a simplified form of Equation 5.1:ˆk (7.1)Whenever investors find that the expected return is not equal to the required
return (ˆkk), a market price adjustment occurs. If the expected return is less than
the required return (ˆkk), investors sell the asset, because they do not expect it to
earn a return commensurate with its risk. Such action drives the asset’s price
down, which (assuming no change in expected benefits) causes its expected return
to rise to the level of its required return. If the expected return were above theExpected benefit during each periodCurrent price of asset